smart beta
Guide
smart beta
Guide
[2]forE word
Foreword
If you are an investor, whether you are the CIO of a large pension fund or an individual
saving for retirement, you should care about factors. Why? Because factors are what drive
the risk and return in your portfolio. The ability to harness factors appropriately can ensure
your investments are working to meet your goals.
In the simplest form, factors are broad, historically persistent drivers of return. These
sources of return are intuitive and well-understood by the marketplace. They are expected
to endure over the long term because they are rewarded for bearing risk, or they arise
through structural impediments or behavioural biases.
Factor investing is a framework that can produce superior diversification, return
enhancements relative to traditional market capitalisation benchmarks, and, done at its
best, becomes an empowering way to manage an entire asset management firm. I have
studied factor investing in academia as a student and as a professor for over 20 years,
and have worked with many institutional investors to put factor investing into practice.
Since my advisory work with the Norwegian sovereign wealth fund in 2009, I have seen an
explosion of interest in this space. I believe wide adoption of factor investing will transform
the asset management industry and the way we all think about our investments.
Just as runners must understand and rely upon the nutrients in their food to ensure they
have the energy to run a marathon, investors can employ specific factors to achieve unique
and personal investment objectives, such as reducing the overall risk of a portfolio, or
enhancing long-term returns.
Factor investing captures these drivers of returns, taking advantage of investment
intuition, diversification and efficient execution. Today, with the introduction of smart beta
strategies, all investors can gain access to many of the same time-tested investment ideas
that have been present in actively managed portfolios for decades, in a transparent and
rules-based vehicle and at a lower cost than traditional active management.
With a growing number of smart beta providers and offerings emerging in the marketplace,
where should an investor turn for help?
I joined BlackRock because I believe this firm is the leader in the factor investing space.
Backed by decades of investment expertise in systematic strategies, industry-leading
research and analytics, and unparalleled execution capabilities, BlackRock is the partner
to help you assess which factors you own, which factors you want to own and how best to
employ specific strategies like smart beta to achieve your unique goals.
This guide is designed to simplify the key considerations behind the investment concept
by providing investors with a deeper look into the what, why and how of smart beta.
I hope this desk reference will be a comprehensive resource as you begin to explore
the potential of factor investing.
I am a true advocate of factor investing and I believe smart beta is THE way we can
empower all investors to access these sources of returns in a simple and affordable way.
s m a r t b e ta G u i d e [3]
[4] s m a r t b e ta g u i d e
Table of contents
Foreword 3
Section 1: Understanding smart beta
Defining smart beta
6
8
10
13
16
20
22
24
26
31
34
36
51
53
Acknowledgements 60
s m a r t b e ta G u i d e [ 5 ]
section 1
Captures well-understood
drivers of return
Subjective oversight
Objective rules
Proprietary
Transparent
Novel
High capacity
Nuanced
[8] u n d e r s ta n d i n g s m a r t b e ta
section 1
Investor
Insight:
If you explain
smart beta to
me, it is the same
as if you explain
medicines. Im
only interested
in what they do,
meaning, whats
the outcome?
Dutch Private Bank
Long Only
Cap-weighted
indices
Smart
beta
Actively
managed
Exposure to
macro factors
High
High
High
Exposure to
style factors
Low
Moderate
Moderate
Potential for
outperformance
None
Moderate
Moderate
to high
Turnover and
trading costs
Low
Low
Moderate
to high
Liquidity and
capacity
High
High
Low to
moderate
Transparency
High
High
Low
Source: Smart Beta: Defining the Opportunity and Solutions, BlackRock, 2015.
s m a r t b e ta G u i d e [9]
section 1
ANNUALISED RETURN
13%
Risk Weighted
High Dividend Yield
Equal Weighted (Size)
12%
Quality
11%
Value Weighted
Minimum Volatility
MSCI World
10%
11%
12%
13%
14%
15%
16%
17%
ANNUALISED RISK
Performance of MSCI World based indices, USD, (28 November 1975 30 June 2015).
Source: BlackRock and MSCI as of June 2015.
[10 ] u n d e r s ta n d i n g s m a r t b e ta
section 1
Seek
outperformance
Base line
Lower volatility
60% S&P/TSX
Capped Composite
Index / 40% FTSE
TMX Canada
Universe Bond
Index
60% MSCI
Canada IMI
Select Diversified
Multiple-Factor
(CAD) Index /
40% FTSE TMX
Canada Universe
Bond Index
Total annualised
return
6.68%
8.10%
9.76%
Total annualised
risk
7.85%
6.39%
8.21%
0.86
1.28
1.20
-25.52%
-20.70%
-26.47%
Allocation
Return to risk
ratio
Max drawdown*
CUMULATIVE RETURN
500
400
300
200
100
0
Jun 01
Jun 03
Jun 06
Jun 09
Jun 12
Jun 15
s m a r t b e t a G u i d e [ 11 ]
section 1
Investor
Insight:
Now, our
philosophy is
all about are
we exposed to
the right factors,
whilst previously
it was still about
45
stock selection,
alpha and
these types
of things.
Dutch Private Bank
Increased transparency
Transparency is a defining attribute of smart beta strategies. Like traditional
index strategies, smart beta strategies follow pre-set rules to determine the
process for security selection, portfolio construction and rebalancing. The
rules are not adjusted for changing market conditions. Often those rules are
published by a third-party benchmark provider. The level of transparency
means investors should have full knowledge of construction rules and portfolio
characteristics, thereby enhancing their ability to make informed allocations
and build more diversified portfolios. Armed with a clear view of the delivered
exposures, investors can be more informed about how a strategy is likely to
perform in various market regimes.
[ 12 ] u n d e r s t a n d i n g s m a r t b e t a
section 1
BROAD UNIVERSE
Bread
Cheese
Muffins
Onions
Jam
Salad
Rice
Corn
Nutrients
Pudding
Ice Cream
Steak
Oranges
Broccoli
Radishes
Chicken Fish
DAIRY MEAT
Eggs Beans
Ham Cereal
Apples Peppers
Potatoes
Mushrooms Strawberries
Carrots
Peas
Milk
Pasta
Sweets
VEG.
FRUIT
GRAINS
Grapefruit
Pastry
Domestic Equity
Real Estate
Large Cap
Diversified Credit
ETFs
Timber
Risk Parity
Emerging
Smart Beta
Markets Private Equity
Leveraged Loans
Energy
ALTS
Direct Lending
TIPS
VALUE
EQUITY
GROWTH
EQUITY
Real Return
Fibre
65%
Protein
25%
Carbohydrates
<1%
Fat
10%
Sodium
<1%
Risk Factors
Commodities
Farmland
Event Driven Small Cap
REITs
Synthetic Overlay
MOST BASIC
ELEMENTS
Cash
Hedge Funds
FIXED INCOME
Value
120 bps
Momentum
75 bps
Inflation
53 bps
Understanding the
nutritional content
drives decisions around
what foods you eat
Understanding drivers
of market returns allow
investors to build more
diversified portfolios
and make better
investment decisions
12 bps
s m a r t b e ta G u i d e [13]
section 1
Equity factor research tends to be much more prevalent than that for other
asset classes, although many of these characteristics persist across other
asset classes as well. Certain factors have positive expected total returns
over the long run, driven by the powerful forces that shape risk preferences,
investor behaviour and market structure. Macro-economic risk factors capture
non-diversifiable risks that have exhibited positive expected return over longer
periods, compensating investors for bearing those risks. For example, holding
nominal bonds exposes the investor to the risk of inflation and the risk of real
rates rising. Within asset classes, there are also commonalities among securities
which we refer to as style factors. Certain (not all) style factors have historically
delivered a positive expected return over the long term as a result of a structural
impediment or behavioural anomaly that shapes the preferences of investors.
Risk factors both macro and style can be captured in transparent, rulesbased portfolios. Only active managers can successfully deliver true alpha, and
alpha is only (persistently) positive for managers with skill.
ALPHA
} Economic
} Real rates
} Credit
} Liquidity
} Inflation
} Emerging
markets
} Value
} Low volatility
} Momentum
} Carry
} Quality
} Curve
} Size
} Convexity
Alpha
Positive alpha requires
manager skill
} Security selection
} Country and industry selection
} Market and factor timing
Source: BlackRock Smart Beta: Defining the Opportunity and Solutions, February 2015.
[14] u n d e r s ta n d i n g s m a r t b e ta
section 1
Investor
Insight:
As our
expectations
for the market
beta premium
lowered following
the financial
crisis, we looked
for additional
sources of alpha.
This happened
3 years ago and
is the reason
why we started
risk premium
investing.
Asian Sovereign
Wealth Fund
s m a r t b e ta G u i d e [15 ]
section 1
What it captures
Common measures
Value
Small size
(Small cap)
Low volatility
High yield
Dividend yield.
Quality
Momentum
Source: MSCI.
[16] u n d e r s ta n d i n g s m a r t b e ta
section 1
Investability
Because the largest institutional investors in the world use our indices, we
have embedded strong controls into our index construction process to ensure
that our indices are highly investable and liquid. Investability requirements
are applied at the overall company level such as full company market
capitalisation represented by the aggregation of all eligible listed and unlisted
securities of a company and at the individual security level, such as free
float-adjusted market capitalisation and liquidity measures.
Our framework for assessing investability has four components: (1) Tradability/
Liquidity, (2) Turnover/Cost of Replication, (3) Capacity and (4) Degree of Active
Tilt. The table overleaf defines each component and provides examples of ways
we measure it.
s m a r t b e ta G u i d e [17 ]
section 1
What it measures
Metrics
Tradability/
Liquidity
Turnover/
Cost of replication
} Index turnover
} Performance drag
Capacity
Degree of
active tilt
} Active share
} Average weight multiplier
} Maximum weight multiplier
} Maximum strategy weight
} Active target factor exposure
Source: MSCI.
Weighting scheme
The weighting scheme used in constructing an index determines its exposures.
The main objectives are to maximise exposure to the target factors, maximise
investability and reduce turnover (and hence rebalancing costs).
Factor indices can be classified into high exposure and high capacity. High
exposure indices are designed to maximise exposure to the target factor
while staying within MSCIs investability guidelines. High capacity indices
are designed to allow very large investments into the index and to focus on
maximising investability and reducing turnover.
MSCI has high exposure and high capacity versions of each of its six single-factor
indices. High exposure indices are constructed by selecting a subset of stocks from
the universe, based on a ranking methodology (typically z scores). High capacity
indices use the entire universe but tilt the weights toward the target factor.
There are two possible weighting schemes for high capacity indices, and both
use the entire universe.
``The first is a score only approach, which takes descriptors and calculates
the score of each stock based on the descriptors. The stocks weight in the
index is then simply the stock score divided by the sum of the score of all
stocks. Our risk weighted indices follow this methodology.
[18] u n d e r s ta n d i n g s m a r t b e ta
section 1
``The second approach is score times market cap, where the market cap of
each stock is multiplied by its score. A stocks weight is simply the market cap
times score divided by the sum of the market cap times the score of all stocks.
The score only approach gives a higher exposure to the target factor but
can lead to significant active weights. In the case of the risk weighted index,
this would mean an exposure to small cap stocks because the descriptor is
variance. Compared to market cap, variance is more stable from stock to stock.
Score times market cap naturally takes the factor index closer to market cap,
increases exposure to large cap stocks (and hence systematic outperformance)
and also increases investability compared to score only.
The chart below illustrates the differences in the high capacity weighting
schemes, score only and score times market cap.
WEIGHT IN INDEX
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
0
150
300
450
600
750
900
1,050
1,200
1,350
1,500
1,650
Source: MSCI.
The x axis shows all stocks ranked in ascending order of market cap and the
y axis shows the weights in the respective indices. The dark blue line shows the
pure market cap index, MSCI World Index. The green line shows the score times
market cap approach and the light blue line shows the score only approach.
The difference between the score only and score times market cap is
significant and leads to some small cap exposure. It is important to note that
other factors will behave differently.
Conclusion
MSCIs factor indices aim to provide a systematic risk-adjusted return
premium by achieving a specified high level of exposure to targeted factors.
MSCI currently offers factor indices that target six factors: Value, Small Size,
Low Volatility, High Yield, Quality and Momentum. Important considerations
in constructing these indices are the trade-off between exposure and
investability, and the indexs weighting scheme.
s m a r t b e ta G u i d e [19 ]
section 1
$BN
250
200
1
18
24
20%
46%
121%
0.3
2.7
7.7
33
32%
3.7
44
49%
5.9
108
23%
-0.6
150
100
50
0
Mar 12
Dividend
Mar 13
Sep 12
Sep 13
Multi Factor
Mar 14
Equal Weight
Sep 14
Mar 15
Minimum Volatility
Sep 15
Single Factor
Fixed Income
YTD Flows
($BN)
US
11.7
US
190.3
Europe
4.2
Europe
20.8
Canada
2.5
Canada
12.4
APAC
1.1
APAC
5.3
LatAm
& Iberia
0.2
LatAm
& Iberia
0.8
0%
25%
50%
[2 0 ] u n d e r s ta n d i n g s m a r t b e ta
0%
50%
100%
Dividend
Equal Weight
Single Factor
Multi Factor
Minimum Volatility
Fixed Income
section
section 11
~$1 in $12
Investor
Insight:
I see potential
for smart beta.
20BN
230BN
If the media
or investors
understand that
many active
exposures
can be easily
replicated with
smart beta ETFs,
45
the potential
increases.
Credit Suisse
Year-by-year smart beta launches globally out of all ETPs since 2012:
16%
16%
30%
23%
2012:
87 of 545
global launches
2013:
85 of 522
global launches
2014:
184 of 619
global launches
92 as of September 2015
Source: BlackRock as of September 2015.
s m a r t b e ta G u i d e [21]
section 2
Investor
Insight:
There is a lot
of dialogue and
conversation
around the
importance
of knowing
your smart beta
products. They
are not created
equal. You have
to look past
the label on
the tin.
EXS Capital
[2 4] a s s e s s i n g s m a r t b e ta
section 2
Clarify the
investment goal
Evaluate potential
performance in
different market
regimes
Understand
the strategys
construction rules
Consider in the
context of your
existing portfolio
Compare the
costs of a
product with its
competitors
Source: BlackRock.
Investor Insight:
Know your benchmark, make detailed comparisons to standard market-cap
benchmarks and understand the behaviours in various scenarios.
Credit Suisse
s m a r t b e ta G u i d e [2 5 ]
section 2
Investor
Insight:
We take a very
conservative
approach.
We would
like to see a
thorough history.
Understanding it
is very important.
The critical
question is:
Why should we
get paid as an
investor and is
it sustainable in
the future?
Dutch Private Bank
To see this, consider a simple one factor model of equity returns where a
stocks return is proportionate to the markets return. If the benchmark return
is represented by the market return, then managers may exceed the average
return on the market only because they maintained a tilt to higher beta stocks
over a period when the market as a whole rose. Such a static factor tilt could
be easily replicated with an ETF, meaning the manager should not receive high
compensation for such outperformance. A manager who successfully avoided
downturns by moving to cash and conversely held the market in upturns,
however, would have genuine or true alpha accruing to their factor timing
abilities. The same is true of a manager who selected stocks that outperformed
but otherwise maintained a beta of one to the market. That skill set deserves to
be rewarded by investors.
An active managers return in excess of their benchmark can be broken down
into three components:
1Sharpe, William F., 1991. The Arithmetic of Active Management, The Financial Analysts Journal
Vol. 47(1), January/February, pages 7-9.
[2 6] a s s e s s i n g s m a r t b e ta
section 2
Active return
(-89 bps)
Static factor
premia
51 bps
Active return
112 bps
Manager skill
(net of expenses)
(-140 bps)
Factor timing
20 bps
Static factor
premia
105 bps
Stock selection
(-160 bps)
Manager skill
(net of expenses)
7 bps
Factor timing
24 bps
Stock selection
(-17 bps)
Source: BlackRock, Bloomberg, Barra, Morningstar, Thomas Reuters, 30 June 2005 to 30 June 2015. Data in USD.
The diagram shows average active return attributions for the set of 1,267
US active style box mutual funds, with US $3.3 trillion in assets, based
on quarterly holdings data for the 10-year period from 30 June 2005 to
30 June 2015. Active returns are calculated with respect to style box
benchmarks defined by Morningstar.2
2See: Smart Beta and Mutual Fund Performance Attribution, by A. Madhavan, R. Nestor,
S. Shores, and A. Sobczyk.
s m a r t b e ta G u i d e [2 7 ]
section 2
Investor
Insight:
Our main concern
in applying
smart beta to our
portfolio is the
crowding effect.
Asian Sovereign
Wealth Fund
Smart beta strategies are centred on factors that are thought to be deep,
fundamental drivers of risk and return. By fundamental we mean that there are
either behavioural or risk compensation drivers of return that are compelling
from a logical, economic perspective and the persistence of which is supported
by the data over a long time frame and relating to diverse regions.
Smart beta strategies motivation by fundamental drivers makes them more
likely to endure when compared to active strategies, the focus of which is
superior information. The best example is value investing, which was well
articulated by Graham & Dodd in 19343, but remains a key component of smart
beta strategies today. Value may succeed because investors chase hot stocks
or because value drivers are correlated with macro-risks and hence yield
compensation for risk over time.
However, deep fundamental drivers are inevitably multi-dimensional and
can be somewhat subtle. For example, when asked to think of momentum,
investors are likely to think of a handful of high-flying basic materials or
technology names, whereas for value they are likely to think about a handful of
consumer staples or business services names. The fact is that risk factors are
the underlying return drivers of all securities in varying degrees of magnitude.
3Graham, Benjamin, David Le Fevre Dodd, and Sidney Cottle. Security analysis. New York:
McGraw-Hill, 1934.
[2 8] a s s e s s i n g s m a r t b e ta
section 2
s m a r t b e ta G u i d e [2 9]
section 2
Investor Insight:
We are long-term investors. Patience is necessary for implementation.
Although we evaluate investments month by month and year by year,
we understand you may need 3 years to capture the premium.
Asian Sovereign Wealth Fund
[3 0 ] a s s e s s i n g s m a r t b e ta
section 2
Value
High Dividend
Momentum
Quality
Size
Minimum Volatility
Correlation
Minimum Volatility
-0.50
Equal Weighted
0.14
Quality
-0.43
Value Weighted
0.05
-0.25
Momentum
-0.11
Risk Weighted
-0.19
Pro-Cyclical Factors
Correlation
s m a r t b e ta G u i d e [31]
section 2
The correlation value illustrates the relationship between a specific factor and
the strength of the economy. For example, a correlation of -0.50 between the
Minimum Volatility Index and the CLI Index indicates that returns to Minimum
Volatility tend to be strong at times when the economy is weak. The defensive
nature of Minimum Volatility, Quality, High Dividend Yield and Risk Weighted
factor indices is clear in this analysis. However, the supposedly pro-cyclical
factor indices Equal Weighted, Value Weighted and Momentum are more
of a puzzle, with only the Equal Weighted index showing a meaningful positive
correlation to the CLI, and the sensitivity of the Momentum index actually
appearing to be negative.
We found that adding a second variable such as inflation (CPI) helps to explain
performance in these cyclical indices.
Inflation (CPI)
Decreasing
Increasing
Decreasing
Increasing
Equal Weighted
0.0%
0.3%
0.2%
0.0%
0.2%
0.1%
0.2%
0.2%
Minimum Volatility*
0.3%
-0.3%
0.0%
0.1%
Momentum
0.2%
0.3%
0.2%
0.3%
Quality
0.3%
-0.1%
0.0%
0.2%
Risk Weighted
0.2%
0.2%
0.2%
0.1%
Value Weighted
0.0%
0.2%
0.1%
0.0%
Source: MSCI. Average active returns relative to MSCI World from December 1975 to December 2013.
*Based on official Index Levels from May 1988. Low Volatility Tilt Index prior to that date includes simulated data.
Looking first at the columns for economic growth, results are similar to our
previous analysis, except that Momentum is now cyclical, with higher active
returns when economic growth is increasing than when it is decreasing.
In the inflation columns, there is no large differentiation between the factor
indices responses.
[3 2] a s s e s s i n g s m a r t b e ta
section 2
Inflation risk
Outperform when
economic growth is strong
Outperform when
economic growth is weak
} Equal Weighted
} Momentum
} Risk Weighted
} Value Weighted
} Small Cap
} Equal Weighted
} Momentum
} High Dividend Yield
} Quality
} Risk Weighted
} Small Cap
} Minimum Volatility
Conclusion
The MSCI Asset Pricing Model shows that Equal Weighted, Momentum, Risk
Weighted, Value Weighted and Small Cap indices showed real GDP growth risk
relative to the capitalisation-weighted index in the long run. Thus, in terms of
sensitivity to economic growth, the long-term model-based analysis broadly
agrees with our historical short-term analysis.
Our frameworks and models have important implications for asset allocation
in developed market portfolios (the basis for this analysis), as shown in
Exhibit 4. Deviations away from a market cap portfolio could logically be
based on an investors expectations about macroeconomic growth and
tolerance for risk.
s m a r t b e ta G u i d e [3 3]
section 3
Objective
Implementation
Tactical
Improve
return
Strategic
Reduce
risk
Implement
investment views
} Implement tactical
views along factor
dimensions
} Introduce explicit
downside risk
protection
Risk management
Improve
return
Reduce
risk
Diversify
Replace and
complement
active strategies
Managing factor
exposure/Completion
strategies
} Improve the
} Implement a
expected risktransparent, welladjusted return
diversified and
while retaining the
low cost alternative
transparency and
to low-risk active
efficiency of beta
strategies
} Complement the
factor exposures of
the existing manager
line up and reduce
unwanted risks
Investor Insight:
For us, one of the most exciting things about smart beta is that it is
helping us build the more exact allocation we want. It means you get
better risk-adjusted outcomes and you have fewer surprises in terms
of how your positions perform.
Credit Suisse
[ 3 6 ] I m p l e m e n t i n g s m a r t b e t a
section 3
Return Objective
MSCI World Enhanced Value
ANNUALISED RETURN
M+V
MV + V + S
7.5%
S+ M + V
M+S
MSCI World Mid-Cap Equal Weighted
MV + Q + V + S
Q+S+M
MV + Q + S
MV + Q + M
V+S
MV + V + M
5.5%
Risk Objective
3.5%
10%
12%
14%
16%
18%
20%
M = Momentum
V = Value
Q = Quality
S = Size
Source: BlackRock and MSCI as of 30 September 2005 30 September 2015. Data in USD.
s m a r t b e ta G u i d e [3 7 ]
section 3
World
Size
World
Momentum
World
Minimum
Volatility
World
Quality
Equal weighted
20.00%
20.00%
20.00%
20.00%
20.00%
Risk weighted
16.83%
19.07%
19.31%
26.07%
18.73%
Allocating factors
in a portfolio
Source: BlackRock. Risk weighted optimisation conducted 30 September 2005 30 September 2015.
[ 3 8 ] I m p l e m e n t i n g s m a r t b e t a
section 3
4%
18%
3%
12%
2%
6%
1%
0%
1 Yr
3 Yrs
5 Yrs
10 Yrs
0%
1 Yr
3 Yrs
5 Yrs
10 Yrs
MSCI World Index
Source: BlackRock, Morningstar, MPI. 30 September 2005 30 September 2015. Data in USD.
s m a r t b e ta G u i d e [3 9]
section 3
[ 4 0 ] I m p l e m e n t i n g s m a r t b e t a
section 3
Portfolio 2:
Balanced Factor Portfolio
Growth
Growth
Financial
Leverage
Volatility
Value
Liquidity
Size
Nonlinearity
Momentum
Size
MSCI World
Portfolio 3:
Dynamic Factor Portfolio
Growth
Financial
Leverage
Volatility
Value
Size
Nonlinearity
Liquidity
Momentum
Size
Financial
Leverage
Volatility
Value
Size
Nonlinearity
Liquidity
Momentum
Size
Dynamic Factor Portfolio
Factor Exposure
Weight
Factor Exposure
Weight
Factor Exposure
Weight
World Minimum
Volatility Factor
33%
20%
33%
33%
World Minimum
Volatility Factor
20%
World Momentum
Factor
33%
33%
World Momentum
Factor
20%
33%
20%
20%
s m a r t b e t a G u i d e [ 41 ]
section 3
The resulting risk and return profiles of the portfolios over a ten-year
period are shown in Figure 18 and behave in line with the initial objectives.
Defensive Portfolio 1 enhances the return slightly versus the benchmark
but allows risk to be reduced on a rolling basis. Balanced Portfolio 2 takes
on a little more risk but performs better than Portfolio 1 on a cumulative
basis. Dynamic Portfolio 3, as was aimed for, achieves the strongest
outperformance but at times has a higher annualised volatility compared
to the benchmark.
CUMULATIVE PERFORMANCE
Oct 05
Oct 06
Oct 07
Oct 08
Oct 09
Oct 10
Oct 11
Oct 12
Oct 13
Oct 14
Oct 15
40%
30%
20%
10%
0%
Oct 05
Oct 06
Oct 07
Oct 08
Oct 09
Oct 10
Oct 11
Oct 12
Oct 13
Oct 14
Oct 15
Source: BlackRock, Markov Processes International (MPI), Morningstar, MSCI, Bloomberg. 5 January 2005 5 October 2015.
Frequency: Day. USD.
[ 4 2 ] I m p l e m e n t i n g s m a r t b e t a
section 3
Sector exposure
North
America
Consumer
Discretionary
Consumer
Staples
Energy
Europe
Financials
Health Care
Pacific
ex Japan
Industrials
Information
Technology
Japan
Materials
Telecom
Services
Israel
Utilities
0%
20%
MSCI World
40%
60%
80%
0%
5%
10%
15%
20%
25%
s m a r t b e ta G u i d e [4 3]
section 3
figure 20: asset allocations with and without the msci world
diversified multiple factor index
Sample: No Smart Beta Indices
Sample portfolio
Sample portfolio
No smart beta
indices
With multiple
factor index
4.75%
6.19%
11.12%
11.16%
0.43
0.56
-36.40%
-35.49%
11/2007 2/2009
11/2007 2/2009
Risk-adjusted return
Max drawdown*
Max drawdown period
Source: BlackRock, MPI. 30 September 2005 - 30 September 2015. Analysis assumes quarterly rebalancing.
Sample portfolios are for illustrative purposes only, and do not represent a recommendation of any security or asset.
* Max drawdown is the peak-to-trough decline during a specific record period of an investment. Data in USD.
[ 4 4 ] I m p l e m e n t i n g s m a r t b e t a
section 3
Sample portfolio
Sample portfolio
No smart beta
indices
With multiple
factor index
4.75%
6.07%
11.12%
9.94%
0.43
0.61
-36.40%
-32.52%
11/2007 2/2009
11/2007 2/2009
Risk-adjusted return
Source: BlackRock, MPI. 30 September 2005 30 September 2015. Analysis assumes quarterly rebalancing. Sample
portfolios are for illustrative purposes only, and do not represent a recommendation of any security or asset. Data in USD.
*M
ax drawdown is the peak-to-trough decline during a specific record period of an investment.
s m a r t b e ta G u i d e [4 5 ]
section 3
Investor
Insight:
Each risk
premium has its
cycle, meaning we
have to balance
the factors.
Asian Sovereign
Wealth Fund
Value
Positive momentum
Low size
High earnings
quality
Inexpensive
companies
Companies on
an upswing
Companies with
illiquidity premiums
Early cycle
recovery
mid cycle
slowdown
late cycle
pick-up
Momentum
quality
quality
Typical behaviour
of global
business cycle
contraction
value
Momentum
size
value
Momentum
For illustrative purposes only.
Sources: BlackRock, Global Return Premiums on Earnings Quality, Value, and Size, 7 January 2013, Max Kozlov and
Antti Petajisto. The opinions expressed are as of 31 March 2015 and are subject to change at any time due to changes
in market or economic conditions.
[ 4 6 ] I m p l e m e n t i n g s m a r t b e t a
section 3
10%
10%
10%
10%
90%
90%
80%
World
Growth
Value
Size
Nonlinearity
Growth
Financial
Leverage
Volatility
Liquidity
Momentum
Size
MSCI World
World Size
Value
Size
Nonlinearity
Growth
Financial
Leverage
Volatility
World Volatility
Liquidity
Momentum
Size
MSCI World - Min Vol tilt
Financial
Leverage
Volatility
Value
Liquidity
Size
Nonlinearity
Momentum
Size
s m a r t b e ta G u i d e [47 ]
section 3
-2
Sep 04
Sep 05
Sep 06
Sep 07
Sep 08
Sep 09
Sep 10
Sep 11
Sep 12
Sep 13
Sep 14
Sep 15
Source: BlackRock, MPI, Morningstar, MSCI, Bloomberg. 31 March 2004 30 September 2015. Frequency: Month. USD.
[ 4 8 ] I m p l e m e n t i n g s m a r t b e t a
section 3
28.60%
19.74%
16.78%
24.31%
3.25%
2.63%
38.91%
45.78%
2.76%
2.24%
MSCI Europe
MSCI USA
MSCI Canada
MSCI Japan
Growth
Value
Size
Nonlinearity
Growth
Financial
Leverage
Volatility
Liquidity
Momentum
Size
Financial
Leverage
Volatility
Value
Size
Nonlinearity
MSCI World
Liquidity
Momentum
Size
Portfolio 1
Portfolio 2
s m a r t b e ta G u i d e [4 9]
section 3
2% World
Momentum
5% World
Global Value
Factor
Fund 32%
World M
om
en
tu
m
Global
Active
Momentum
Fund 23%
Global
Equity Index
Fund 35%
W o rld E T F O ve
For illustrative purposes only.
Source: BlackRock, MSCI, data as of September 2015.
[ 5 0 ] I m p l e m e n t i n g s m a r t b e t a
Global
Equity Index
Fund 40%
3% World
Value
World Value
Global
Active
Momentum
Fund 25%
%
y3
rla
ay 2%
verl
FO
ET
Global Value
Factor
Fund 35%
ET
FO
ve
Original Portfolio
rla
y5
section 3
CLS Investments (CLS), a third party investment manager and ETF Strategist,
uses risk-managed, globally balanced portfolios to enhance the investor
experience. A firm believer in the power of risk budgeting delivered through
outcome-based investment options, CLS manages risk and investments for
those seeking to accumulate wealth, generate income, protect their assets
or manage tax within their portfolios.
Today, CLS manages nearly US$ 6BN for more than 35,000 investors.
s m a r t b e ta G u i d e [ 51]
section 3
Figure 28: Usage of Smart Beta ETFs: March 2012 vs March 2015
Holdings as of 31 March 2012
``CLSs smart beta ETF usage has nearly quadrupled since 2012 (as a percentage of holdings).
``Historically, CLSs usage of smart beta ETFs consisted mainly of dividend-focused funds and
revenue-weighted products.
``CLSs current smart beta usage expands to factors, equal weighting, dividend weighting, etc.
as ETFs that focus on exposure to individual factors become available.
Source: CLS Investments.
[ 5 2 ] I m p l e m e n t i n g s m a r t b e t a
section 3
``better diversification
``improved risk-return profiles
``precision exposure to specific factors or market anomalies
s m a r t b e ta G u i d e [ 5 3]
section 3
3.0%
25%
2.5%
20%
2.0%
1.5%
15%
1.0%
10%
0.5%
5%
0.0%
-0.5%
Barclays US
Aggregate Index
Rates contribution
Risk Balanced
Strategy
Spread contribution
0%
Barclays US
Aggregate Index
Rates contribution
Risk Balanced
Strategy
Spread contribution
Source: Barclays and BlackRock. Charts based on the monthly returns of the Barclays US Aggregate Index and the
risk balanced strategy from January 2010 to March 2015. Data in USD.
Left chart: the risk is measured by 24 realised volatility (annualised) averaged over the last five years.
Index performance is shown for illustrative purposes only. One cannot invest directly in an index.
[ 5 4 ] I m p l e m e n t i n g s m a r t b e t a
section 3
Volatility
Return over
volatility
Yield to
maturity
Barclays US
Aggregate Index
6.0%
3.6%
1.7
2.1%
5.8%
2.6%
2.2
2.8%
Source: BlackRock and Barclays. Figures calculated over the period from December 1991 to
March 2015. Returns and volatility are annualised. Yield to maturity is as of March 2015. Index
performance is shown for illustrative purposes only. One cannot invest directly in an index.
Commodities
Commodities offer diversification benefits as well as some inflation protection.
Commodity exposure is mainly achieved through rolling positions on futures
contracts because of various complications of trading them physically. This
investment approach has an impact on the total return of the position, which
can be broken down into three components:
Spot return
Change in the spot
price of the underlying
commodity
Roll return
Return associated with
the process of moving
(rolling) between one
futures contract as it
matures to the next
Collateral return
Return obtained
through the purchase of
a risk-free investment
These are important aspects that should feed into index construction along
with various other considerations such as:
s m a r t b e ta G u i d e [ 5 5 ]
section 3
The first generation of commodity indices, such as S&P GSCI, as well as the
Bloomberg Commodity Index allocate to a broad set of commodities and
consider characteristics such as quantity of production as well as liquidity
of contracts for selection and weighting. While this approach provides broad
exposure to the commodities market, it leaves investors vulnerable to certain
important features such as negative roll yield because of the persistent
headwind that results from rolling future contracts. Second generation indices
include specific features that reduce the impact of negative roll yield, look
to capture wider futures curve exposure via investments across multiple
maturities, use modified rolling windows and modified contract schedules
as well as capture seasonality effects (certain commodities exhibit strong
seasonality due to supply and demand dynamics).
Jul 95
Jan 98
Jul 00
Jan 03
Jul 05
Jan 08
Jul 10
Jan 13
Return
6.49%
2.75%
Volatility
13.95%
14.91%
0.47
0.18
-51.93%
-60.19%
Jul 15
[ 5 6 ] I m p l e m e n t i n g s m a r t b e t a
section 3
s m a r t b e ta G u i d e [ 5 7 ]
section 3
[ 5 8 ] I m p l e m e n t i n g s m a r t b e t a
s m a r t b e ta G u i d e [ 5 9]
Acknowledgements
BlackRock would like to thank those who have generously shared their insights
for this guide:
MSCI Inc.
MSCI Inc. is a leading provider of investment decision support tools to investors
globally, including asset managers, banks, hedge funds and pension funds.
MSCI products and services include indices, portfolio risk and performance
analytics, and ESG data and research. MSCI is headquartered in New York,
with research and commercial offices around the world.
Asian Sovereign Wealth Fund
An Asian sovereign wealth fund with a mandate to manage assets entrusted by
its government and central bank.
CLS Investments, LLC
CLS Investments (CLS), a third party investment manager and ETF Strategist,
uses risk-managed, globally balanced portfolios to enhance the investor
experience. A firm believer in the power of risk budgeting delivered through
outcome-based investment options, CLS manages risk and investments for
those seeking to accumulate wealth, generate income, protect their assets,
or manage tax within their portfolios. Today, CLS manages nearly US$6BN for
more than 35,000 investors.
Credit Suisse
Credit Suisse Multi Asset Class Solutions (MACS) develops and implements
investment allocation strategies across asset classes for both private
and institutional clients. Credit Suisses solutions can combine traditional
investments, such as cash, bonds and equities, with non-traditional alternative
investments to meet clients needs. The product range includes funds and
certificates to discretionary mandates, covering retail clients to ultra-high
net worth individuals.
[60]acknowledgements
s m a r t b e ta G u i d e [61]
s m a r t b e ta g u i d e
section 1
www.iShares.ca
The information contained herein is not investment and/or tax advice and is not tailored to the needs or circumstances of any specific
investors. The case studies are provided only as examples of possible ways to invest.
iShares Funds are managed by BlackRock Asset Management Canada Limited. Commissions, trailing commissions, management
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2016 BlackRock Asset Management Canada Limited. All rights reserved. iShares and BlackRock are registered trademarks
of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. Used with permission. 484-01/16
s m a r t b e ta G u i d e